A Brief Guide to How Stablecoins Work

New crypto enthusiasts prefer to invest in tried-and-tested digital currencies like Bitcoin and Ethereum. And while the decision to invest in these old-timers isn’t devoid of logic and common sense, it’s important to note that there’s no such thing as an immutable crypto. So, when choosing your ‘ideal’ token, you should consider a lot of factors, including potential risk and, most importantly, your preferred crypto’s volatility.

Even such titans as Bitcoin have their limitations, with high volatility being one of the most prominent ones. Exactly this shortcoming is responsible for financial institutions’ reluctance to embrace Bitcoin and Ethereum. As for businesses, they are also slow to adopt hyped cryptos for fear of their incredible volatility and unpredictability.

But what if we told you there’s a great alternative to Bitcoin, which was created with added stability in mind?

What’s in a Stablecoin? 

Stablecoins are a great crypto phenomenon that is definitely worth a closer look. This type of crypto is claimed to be capable of maintaining a stable value by pegging their value to the value of a specific currency or commodity. Hence, its low fluctuation and stability. However, not all stablecoins achieve this goal in the same way. So, before you start using the new tokenized digital dollars, make sure they can suit your individual or business needs.

Depending on the mechanism a stable coin uses, it can be placed into one of three main categories: fiat-backed, crypto-backed, and algorithmic.

Fiat-Based Currencies

The first category of stablecoins is fiat-backed currencies like UCDT and USDC, which are currently supported by all popular exchanges and cryptocurrency payment processing platforms. These digital coins are backed by the reserves of traditional physical currencies, such as the US dollar or the euro. To maintain their 1:1 peg to a currency, the stablecoin issuer ideally holds the currency in cash or cash equivalent, such as treasuries, which should match or exceed the circulating supply of the stablecoin.

Crypto-Backed Currencies

As their name suggests, crypto-backed tokens originate from DeFi applications and are backed by the crypto held as collateral. However, due to the volatile nature of all cryptocurrencies, stables typically require over-collateralization to a specific ratio to ensure stability. For instance, a collateralization ratio requirement of 150% means a user needs to deposit $150 worth of crypto to mint $100 of a stablecoin.

Examples of crypto-collateralized coins include DAI, which is currently the largest crypto-backed stablecoin by market capitalization, and LUSD, which is 100%-backed by ETH. It’s also worth mentioning that even though DAI was designed to be a decentralized coin, its collateral includes a large percentage of USDC, USDP, and GUSD, which are centralized, fiat-backed stablecoins.

Algorithmic Currencies

The third category is algorithmic stablecoins, which also were conceived as decentralized digital assets. Nevertheless, unlike their over-collateralized counterparts, they may or may not actually be backed by anything. Instead, they rely on algorithmic and incentive mechanisms to maintain their price stability. However, this mechanism has historically not been sustainable since it is dependent on consistent demand being there for the stablecoin. And once this disappears, they go into the so-called ‘dead spiral,’ where the mechanism collapses the stablecoin. Basis Cash, Empty Set Dollar, Titan, and most infamously, Terra’s UST are some examples of failed algorithmic stablecoins.

Other Types of Stablecoins

These are the three main categories, but there are also other stables that don’t fit neatly into them. Let’s take FRAX, which launched as the first partially-algorithmic stablecoin. The recent community vote, though, decided to shift this coin to a fully crypto-collateralized model over time. Meanwhile, some stables peg their value to physical assets like precious metals or other commodities like Paxos Gold and Tether Gold, which claim to hold physical gold in reserves.

Finally, there are even non-pegged coins like RAI, which are crypt-backed but do not have their value tied to any specific asset. Therefore, it can fluctuate based on supply and demand.

If you’re wondering why all the different designs, it’s worth noting that like the blockchain trilemma of security, decentralization, and scalability, stablecoins also face their own problem of stability, decentralization, and capital efficiency, whereby any coin design typically has to sacrifice one aspect to achieve the other two. So far, the race to create a stable currency, that would effectively combine all three aspects, is still on.

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Libby Austin

Libby Austin, the creative force behind alltheragefaces.com, is a dynamic and versatile writer known for her engaging and informative articles across various genres. With a flair for captivating storytelling, Libby's work resonates with a diverse audience, blending expertise with a relatable voice.
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